Economics 314 Coursebook, 2019 Jeffrey Parker

18 FISCAL POLICY

Chapter 18 Contents

A. Topics and Tools ............................................................................. 1

B. Issues in Fiscal Policy ...................................................................... 3

Countercyclical fiscal policy ........................................................................................... 3

Automatic stabilizers .................................................................................................... 4

Fiscal policy lags .......................................................................................................... 5

Crowding out ............................................................................................................... 6

Ricardian equivalence ................................................................................................... 6

Sustainability of debt .................................................................................................... 7

C. Understanding Romer’s Chapter 13 ..................................................... 8

Government budget constraint ....................................................................................... 8

Ricardian equivalence ................................................................................................... 9

Problems with Ricardian equivalence ........................................................................... 10

Tax smoothing ........................................................................................................... 10

Political-economy models ............................................................................................ 11

A final puzzle ............................................................................................................. 12

D. Suggestions for Further Reading ........................................................ 13

Measuring the government deficit ................................................................................. 13

Ricardian equivalence and the effects of deficits .............................................................. 13

Sustainability of deficits .............................................................................................. 13

E. Works Cited in Text ........................................................................ 13

A. Topics and Tools

The economics of government expenditures and taxation can be viewed on either

a microeconomic or macroeconomic level. In microeconomics we study the reasons

why governments might undertake economic activity—providing public goods, assur-

ing a mechanism for security of property rights, redressing externalities, redistributing

income, etc. We also study the details of how different methods of collecting revenue

and distributing benefits affect the incentives for private economic activity.

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On a macroeconomic level, we are usually more concerned with the aggregate

levels of spending, taxes, and transfers. This includes both variations in the overall size

of government—big government vs. small government— and changes in the balance

of government income and outlays—issues of government deficits and debt. These are

the issues we put in the category of fiscal policy.

Economists’ interest in fiscal policy evolved greatly in the twentieth century. Be-

fore Keynes, the microeconomic view dominated. Government programs should be

based on one of the microeconomic justifications for government intervention in the

economy, and they should be funded by direct taxation. Only in emergencies (usually

wars) was it thought to be appropriate for governments to borrow.

Keynes took a radically different view of fiscal policy. He interpreted the Great

Depression as a case of insufficient aggregate demand. With short-term nominal inter-

est rates hovering near zero (a liquidity trap), Keynes did not believe that falling prices

or expansionary monetary policy could provide the needed stimulation to aggregate

demand. His primary policy recommendation was that government should increase

spending (without raising taxes) to put more income into the hands of the public,

“priming the pump” for additional private expenditures through the multiplier. Thus,

the Keynesian economists who dominated post-World-War-II policymaking were pos-

itively disposed to the use of fiscal policy for countercyclical stabilization.

In some ways, fiscal policy is ideal for stabilization. With progressive taxes and

entitlement-based transfer programs, taxes fall and transfer payments rise automati-

cally when the economy enters a recession, providing an automatic stabilizer to the

economy. However, discretionary fiscal policy proved more problematic because it

often took a long time to put a fiscal policy action into place, raising the likelihood of

mistimed policies that could prove destabilizing.

By the 1970s, most economists placed responsibility for countercyclical policy with

monetary policy, and fiscal stabilization policy became an intellectual backwater.

However, at the same time a theoretical controversy arose (provoked by, who else,

Robert Barro) over the potential effects of government deficits. Because government

budgets in most of the world careened wildly into the red during the last part of the

century, the impact of these deficits and the resulting debts became the target of an

extensive theoretical and empirical debate. The Ricardian equivalence controversy kept

interest in fiscal policy alive through the 1980s and 1990s.

Now that most industrial countries have their deficits under control, interest has

swung back to the possibility of using fiscal policy for stabilization. This revival has

been sparked by the actions of many countries—especially those of the European Un-

ion—to unite their currencies or to peg them “irrevocably” to a foreign currency. This

action eliminates monetary policy as a potential tool for stabilization, since the money

supply must be used to preserve the fixed exchange rate or, in the case of currency

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union, the money supply is no longer under the country’s control. That leaves fiscal

policy as the only candidate for macroeconomic stabilization.

B. Issues in Fiscal Policy

Countercyclical fiscal policy

Increasing government spending or lowering taxes should stimulate aggregate de-

mand in the economy, making fiscal policy a potential tool for countercyclical stabili-

zation. In the traditional Keynesian framework, fiscal policy affects aggregate demand

by shifting the IS curve. Thus, the magnitude of the demand shift that results from a

given change in the fiscal variables depends on the amount by which the IS curve shifts

and on the slope of the LM curve.

The basis for arguing that expansionary fiscal policy leads to higher demand rests

on the assumptions that increases in government spending do not cause equal reduc-

tions in other components of spending and that tax cuts raise households’ disposable

income (or wealth) and thus induce higher consumption spending. As we shall see

below, both of these assumptions are open to challenge. Some kinds of government

spending are close substitutes for private spending, thus may simply lead to direct re-

ductions in other expenditures. If current tax cuts imply higher future taxes and house-

holds are forward-looking, then lifetime wealth and consumption may be unaffected

by changes in taxes.

The strongest case for fiscal policy as a tool of stabilization policy can be made

when the LM curve is relatively flat. There are several situations in which this may

arise. The first is the liquidity trap, which occurs when nominal interest rates are near

zero. In a liquidity trap, interest rates become insensitive to changes in the money and

asset markets because individuals in the economy have an insatiable desire to hold

money rather than bonds at a zero nominal interest rate. This means that expansionary

fiscal policy can effect large changes in aggregate demand without incurring the damp-

ening effect of rising interest rates. Many think that a liquidity trap occurred in the

United States in the 1930s, when interest rates on short-term government securities

were very small. Interest in the liquidity trap has revived recently as nominal interest

rates in Japan have hovered near zero.

A second situation where the LM curve is flat is when the central bank is strongly

committed to an interest-rate pegging policy. Fixing the interest rate with monetary

policy amounts to making the LM curve horizontal at the chosen interest rate. Thus,

the effect of expansionary fiscal policy will again be strong, reinforced by accommo-

dating monetary expansion in order to keep interest rates from rising.

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Finally, although it is no longer covered in Romer’s text, the Mundell-Fleming

model of an open economy with perfect capital mobility has much the same effect as

a horizontal LM curve in the case where the central bank pegs the exchange rate. This

model is highly relevant to countries in a currency union such as the members of the

euro area. In this case, expansionary fiscal policy would start to push domestic interest

rates up above the world level, which would put upward pressure on the domestic

currency. To counter this pressure and maintain the exchange-rate peg, the central

bank would be forced to expand the domestic money supply as it buys foreign cur-

rency, which again reinforces the expansionary effects of fiscal policy.

Thus, the strongest cases for using fiscal policy as a tool of countercyclical stabili-

zation are in situations where monetary policy is either ineffective (the liquidity trap)

or being dedicated to an alternative goal (stabilization of interest rates or the exchange

rate). Keynes made a plea in the General Theory for the use of fiscal policy to get out of

the Great Depression:

If the Treasury were to fill old bottles with banknotes, bury them at

suitable depths in disused coal-mines which are then filled up to the

surface with town rubbish, and leave it to private enterprise on well-

tried principles of laissez-faire to dig the notes up again …, there need

be no more unemployment and, with the help of the repercussions, the

real income of the community, and its capital wealth also, would prob-

ably become a good deal greater than it actually is. It would, indeed,

be more sensible to build houses and the like; but if there are political

and practical difficulties in the way of this, the above would be better

than nothing. (Keynes (1936))

Automatic stabilizers

Some fiscal policy actions occur automatically without a policy decision. These

are called automatic stabilizers. In most countries, taxes are not fixed in amount but

depend on the amount of income, expenditure, or production that goes on in the econ-

omy. The amount of income tax collected increases and decreases with the amount of

income earned. Similarly, taxes on sales or production move in parallel with GDP.

This means that during recessions, when GDP falls, tax payments will decrease.

This provides a degree of expansionary fiscal policy that tends to boost the economy

and mitigate the depth of the downturn—automatic stabilization.

Similarly, many government transfer payments are distributed as entitlements. An-

yone who meets the qualifications of being unemployed or of having low income can

receive unemployment benefits or income-support payments such as welfare or food

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stamps. Since the number of people qualifying for assistance increases during a reces-

sion, the volume of transfer payments increases automatically, again providing a de-

gree of stabilizing fiscal policy.

Automatic stabilizers can only work if it is feasible for the governmental unit to

run ex-post deficits and surpluses. For the U.S. federal government, this is obviously

not a problem because the credit market has lenders eager to buy Treasury bills and

bonds. This is not true for some developing countries, who must rely on the central

bank to finance recession-induced deficits through money creation. Moreover, many

U.S. state and local governments are prevented by their own constitutions from run-

ning deficits. In these cases, they may be forced to cut discretionary expenditures or

increase tax rates during downturns in order to keep their budgets balanced—hardly

an appropriate fiscal policy stance.

Fiscal policy lags

One of the biggest problems with using discretionary fiscal policy to counteract

business cycles is the lag involved in fiscal-policy action. As with monetary policy, the

makers of fiscal policy must first recognize the need for a policy change. This recogni-

tion lag can cause policy action to be initiated many months after the beginning of a

cyclical turnaround.

For monetary policy, once the need for action has been recognized, the actual pol-

icymaking process can be very quick. It is usually quite easy for the Federal Open

Market Committee to agree to raise or lower the federal funds rate. The members of

the FOMC are all economists or bankers, so they tend to share a common view of the

world. None is elected to his or her position, so there is no posturing for the voters,

and their meetings are held in secrecy anyway. Finally, the federal funds rate is a single

number—the only debate is over whether and how much to change it.

In contrast, the decision lag for fiscal policy can be a serious impediment. In order

to enact a fiscal policy change, both houses of Congress must agree on changes in the

federal budget. This is done in partisan, public debate with all sides trying to score

points with their constituents. Moreover, even if everyone agreed that government

spending should go up by $100 billion, there are thousands of different programs on

which this additional money could be spent. Before the budget bill can be passed, the

majority must agree not only on the fiscal policy aspect (the overall amount of spend-

ing and taxes), but on the composition of expenditures and taxes. The frequency with

which Congress misses its deadline for passing the budget and must keep the govern-

ment operating with “continuing resolutions” testifies to the difficulty of achieving

consensus on fiscal policy.

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Crowding out

As noted above, it is possible that the expansion of demand resulting from an in-

crease in government spending could be offset, partially or even completely, by a de-

cline in other components of spending. When government spending simply replaces

private spending, the latter is said to be crowded out.

Direct crowding out occurs when the government buys something, say school

lunches, that private buyers would otherwise have purchased for themselves. To the

extent that overall private consumption or investment falls as the government buys

things for people, the aggregate demand expansion is reduced.

Indirect crowding out happens when an increase in government spending raises

interest rates, leading to a reduction in private investment (and perhaps consumption).

If the LM curve is steep, then interest rates will rise substantially when fiscal policy

expands, and there will be a large offsetting effect on private spending.

Of course, the long-run aggregate supply curve is vertical. Therefore, in the long

run the economy tends to return to the full-employment level of output after any shock.

With overall output fixed, any change in government spending must be offset by a

long-run decline in another spending component. Thus, crowding out is more com-

plete in the long run than the short run.

Ricardian equivalence

While most of the above discussion of fiscal policy has used a Keynesian frame-

work such as IS/LM, much of the recent research on fiscal policies has focused around

a strongly neoclassical proposition. Robert Barro posed the question in the title of a

1974 article: “Are government bonds net wealth?” The prevailing wisdom at the time

was that people in the economy would treat government bonds as net wealth. They

are assets of the individuals who own them without being liabilities of other individu-

als.

Barro pointed out that while no individual owes repayment of government bonds,

all individuals bear this debt collectively. Since the government will have to use future

tax revenues to make principal and interest payments on these bonds, forward-looking

taxpayers should recognize this liability and accordingly lower their assessments of

their wealth. If they do, then the taxpayers’ liability will offset the bond-owner’s asset

and the net wealth associated with government bonds will be zero.

Barro went on to show analytically that consumers of the kind assumed in the

Ramsey growth model (infinitely lived and consumption smoothing) will respond to a

change in government spending in the same way whether it is financed by an increase

in current taxes or by borrowing and running a deficit (i.e., by future taxes). This re-

markable result, which we discuss further below in support of Romer’s analysis, is

called the Ricardian equivalence theorem. A good survey of opinions for and against

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Ricardian equivalence can be found in a Journal of Economic Perspectives symposium

cited at the end of this chapter.

Sustainability of debt

A final issue that has attracted a lot of attention from economists in recent decades

is the degree to which government debt can be sustained indefinitely by simply bor-

rowing more money in the future to repay current bonds. The conventional way of

assessing whether an individual is overly indebted is to compare her net debt to her

income. For governments, “income” is the capacity to collect tax revenue, which is

probably roughly proportional to real GDP in the economy. Thus, the debt/GDP ratio

is often used as a guideline for measuring the degree to which a country’s debt is po-

tentially problematic.

In the United States, the debt/GDP ratio has varied widely, as shown in Figure 1,

which shows data taken from Table B-79 of the 2012 Economic Report of the President.

The lower line represents the part of the debt that is held by the public; the remainder

is owned by government agencies such as the Federal Reserve and the Social Security

Trust Fund, so the lower line is the net federal debt. Figure 1 shows that the net U.S.

federal debt has varied from as high as 108.6% of GDP at the end of World War II

down to 23.8% in 1974.

The change in the debt from year to year depends on the government’s deficit. It

is convenient to look at the government’s “primary deficit,” which excludes govern-

ment interest payments on the debt. The total deficit is the primary deficit plus interest

payments. If the real value of the debt at time t is D(t) and the primary deficit is G(t)

T(t), then

( ) ( ) ( ) ( ),D t rD t G t T t (1)

where r is the real interest rate on government bonds. Consider a government that

balances its primary budget, so that G(t) T(t) = 0 for all future time. Would that

government ever have to pay back its current debt or could it “roll it over” forever?

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Figure 1. U.S. debt/GDP ratio, 1939–2011

If the government’s debt evolves according to (1) with G(t) T(t) = 0, then the

change in the debt/GDP ratio is

,

Dd

D D Y DYr g

dt Y D Y Y

where g is the growth rate of real output. Thus, the debt/GDP ratio will be growing,

even if the primary deficit is zero, if the real interest rate exceeds the growth rate of the

economy. Countries that have growth rates that exceed the interest rate seem to be

able to roll over their existing debt forever. However, in a country where the interest

rate exceeds growth, the debt/GDP ratio will keep accelerating until lenders begin to

question the government’s ability to repay. As that begins to happen, the interest rate

on government bonds is likely to rise, making the debt/GDP ratio grow even faster.

C. Understanding Romer’s Chapter 13

Government budget constraint

Just like individuals and firms, governments must generate revenue to support

their expenditures. Credit-worthy governments may borrow at some times in order to

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spend more than their current revenues, but the creditors who finance such deficits

must eventually be repaid.

Romer describes the budget constraint of a government in his equations (13.1)

through (13.4). Coupled with the discussion of the role of inflation in the following

section, the bottom line is that all government expenditures must be financed by one

of three means:

present taxes,

future taxes, or

the inflation tax.

Romer also points out some serious difficulties with how government deficits are

measured. From the standpoint of private accounting systems, government accounting

is peculiar in emphasizing liabilities (debt) but ignoring assets. Financial analysts

would look very differently at a private company that goes into debt to finance a highly

productive factory than at one that incurs debt to pay high salaries to its executives.

Thus, looking at government debt but ignoring assets that will provide governmental

services for many future years may not give an accurate picture of a government’s

financial position.

Another issue that Romer mentions is unfunded liabilities, which are promises that

the government makes to spend money in the future, without making corresponding

changes in the tax structure to provide supporting revenue. Most advanced countries

are facing huge prospective deficits in pension and medical care programs as the baby

boom generation reaches retirement. Thus, today’s government deficit may easily be-

come a huge deficit in twenty years even with no change in fiscal policy.

Ricardian equivalence

On pages 669 and 670, Romer uses the household intertemporal budget constraint

from the Ramsey growth model along with the government budget constraint to derive

equation (13.11). This equation establishes the remarkable result that the household’s

lifetime budget constraint depends only on the present value of lifetime government

spending (and lifetime taxes) and not at all on when tax revenues are collected.

Since households’ consumption decisions depend only on their utility functions

and the budget constraint, and since both of these are unaffected by a change in the

timing of taxes, this demonstrates the remarkable conclusion of Ricardian equivalence:

financing current government spending by borrowing rather than by current taxes does

not affect households’ consumption paths. Because a reduction in current taxes gives

more current income to households, the only way that their consumption can be un-

affected is if they save all of the tax cut.

Why would rational households save all of the money that the government gives

back with a deficit-financed tax cut? As taxpayers, they recognize that the government

has incurred a liability on their behalf. The bonds being issued today to finance the tax

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cut will have to be repaid in the future out of tax revenues. In order to accumulate the

money to pay these future taxes (while keeping consumption smooth), households

must “invest” the tax savings in an interest-earning asset. In fact, they can just buy

government bonds with the money that they would have paid in taxes, using the pro-

ceeds from the maturing bond to pay the future taxes. If we think of one individual

doing all of this, it is obvious that she is simply paying herself back: sending in extra

taxes and getting them back by redeeming the bond.

Thus, the Ricardian equivalence hypothesis shows that rational, infinitely lived

households would respond to government borrowing by increasing the supply of sav-

ing, leaving interest rates in credit markets unaffected. This implies that there would

be no crowding out due to a tax cut. In fact, the IS curve would not shift at all because

consumption would not increase.

Problems with Ricardian equivalence

Critics have pointed out that many of the assumption underlying the Ramsey

model (and therefore the Ricardian proposition) are unrealistic. Among the more ob-

vious difficulties are the assumption of infinite lifetimes and perfect credit markets.

If lifetimes are finite and present-day citizens do not care about their descendents,

then it is possible that today’s consumers will not be consider the repayment of current

deficits as a liability. Since everyone agrees that lifetimes are finite, the crucial empiri-

cal question is whether the current generation values the utility of the next generation.

If the next generation’s utility is valued as highly as the present generation’s (appropri-

ately discounted for the fact that it is in the future), then the Ricardian result still holds

with finite lifetimes.

Liquidity constraints can also lead to non-Ricardian outcomes. An individual with

low current income who lacks access to credit markets will usually spend nearly all of

her current income—that is as close to consumption smoothing as she can get. Reduc-

ing such an individual’s taxes gives her more current income and she is likely to spend

most of it.

Tax smoothing

In section 13.3, Romer points out another crucial assumption of Ricardian equiv-

alence—that taxes are lump-sum. With lump-sum taxes, it does not matter when they

are collected because they do not distort economic decisions. However, taxes in the

real world are never of a lump-sum nature. Instead the tax an individual pays depends

on his income, expenditures, or other economic decisions.

Given these distortions, it is likely to be beneficial to avoid raising tax rates to

extremely high levels at any point in time. Thus, the most efficient way to finance a

given long-run pattern of government expenditure is by smoothing tax rates over time.

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Political-economy models

Beginning in Section 13.5, Romer introduces a series of models of fiscal policy that

endogenize the political decision-making process. Models in which political and eco-

nomic variables and modeled jointly are often called political-economy models.1

The political decision-making process in these models can feature varying degrees

of sophistication. The simplest specification is to assume perfectly democratic decision

making by agents whose distribution of preferences over outcomes is known. If the

preferences of the voting population has certain regular properties, then the democratic

outcome is the one preferred by the median voter, whose preferences lie at the center

(50th percentile) of the population.

Consider voting for the amount of a public good to provide. If the amount pro-

posed is above the amount preferred by the median voter, then a majority of voters

would favor reducing provision. If the amount is below the median voter’s preference,

then a majority favor increasing the amount. Only if the amount is exactly at the me-

dian voter’s preferred level will there be no majority in favor of changing. Thus, we

often model democratic decisions by appealing to the preferences of the median voter.

Of course, few decisions in modern economies are made by direct democracy.

More sophisticated models take into account the behavior of elected officials. Depend-

ing on the model, elected officials may be purely opportunistic, advocating whatever

policies will get them elected (or re-elected). Or they may have preferences of their

own, which must be balanced against the need to appeal to a majority of voters.

In Section 13.5, Romer describes a model of “strategic debt accumulation.” This

model builds on the work of Tabellini and Alesina (1990) looking at how incumbents

may strategize to constraint their successors. This paper was motivated by the paradox

of a conservative president (Ronald Reagan) running massive budget deficits. The es-

sence of their argument is that by accumulating a huge amount of debt and spending

the proceeds on his preferred targets (military spending), he would effectively constrain

his successor’s ability to spend on alternative priorities.

The “delayed stabilization” model of Section 13.6 shows how undesirable policies

such as deficits may persist because of strategic behavior on the part of two parties who

attempt to steer reform in opposite directions. The inability to agree on a reform may

cause deficits to persist longer than they otherwise would.

1

The term “political economy” has a long and varied history. The earliest economists were

professors of political economy. More recently, the term was used in the 1960s and 1970s as a

euphemism for Marxist models. Lately, the term has resurfaced to refer to models in which

both political and economic outcomes are endogenous.

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A final puzzle

One of the most intriguing criticisms of the Ricardian equivalence hypothesis

comes from Gordon Tullock and is called Tullock’s Fallacy:

In general, we have to pay our taxes to the government in the year that

they come due. Clearly, however, we would be better off if that were

loosened up. For example, suppose that I can pay this year’s taxes and

next year’s taxes in the corresponding years, or I can pay them both

this year having a discount on next year’s taxes equivalent to the rate

of interest, or I can pay them next year with an interest payment added

on this year’s taxes. Clearly, I have added flexibility and would be bet-

ter off.

As a matter of fact, that is the present situation for those members of

the population with good credit. I can pay next year’s taxes this year

by the simple expedient of buying an adequate quantity of government

bonds, and I can borrow money to pay this year’s taxes and then pay

it back with interest next year. Clearly, these additional opportunities

benefit me: I have greater freedom in making my tax payments.

But let us suppose that the government decides to benefit me even fur-

ther. Suppose they notice that the interest rate that they have to pay is

lower than the interest rate that I have to pay and, in additional, their

credit is good so they can always borrow money. They, thus, borrow

money for all of their expenditures this year and permit individuals to

purchase an adequate quantity of bonds to cover this year’s tax liability

or wait until next year. The interest that the individual pays if he or she

waits until next year will be lower although the interest received if he

or she pays this year will be the same. Clearly this is a “super-Pareto”

move. Not only is nobody injured, a great many people would be ben-

efited.

From this line of reasoning, we reach the conclusion that the govern-

ment should collect no taxes this year, they should borrow money and

then should collect this year’s taxes plus interest next year. But note

that the same line of reasoning would apply next year, and the next,

and the next.... This is Tullock’s fallacy, and I should warn the reader

that although it is obviously a fallacy, it is very hard to put your finger

on exactly what is wrong with it. (Tullock (1991))

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D. Suggestions for Further Reading

Measuring the government deficit

Blejer, Mario J., and Adrienne Cheasty, “The Measurement of Fiscal Deficits: Ana-

lytical and Methodological Issues,” Journal of Economic Literature 29(4), December

1991, 1644-78.

Ricardian equivalence and the effects of deficits

Barro, Robert J., “Are Government Bonds Net Wealth?” Journal of Political Economy

82(6), November/December 1974, 1095–1117.

Bernheim, B. Douglas, “A Neoclassical Perspective on Budget Deficits,” Journal of

Economic Perspectives 3(2), Spring 1989, 55-72.

Barro, Robert J., “The Ricardian Approach to Budget Deficits,” Journal of Economic

Perspectives 3(2), Spring 1989, 37-54.

Sustainability of deficits

Sargent, Thomas J., and Neil Wallace, “Some Unpleasant Monetarist Arithmetic,”

Federal Reserve Bank of Minneapolis Quarterly Review 9(1), Winter 1985, 15-31.

E. Works Cited in Text

Keynes, John Maynard. 1936. The General Theory of Employment, Interest and Money.

New York: Harcourt, Brace. Tabellini, Guido, and Alberto Alesina. 1990. "Voting on the Budget Deficit."

American Economic Review 80 (1):37-49.

Tullock, Gordon. 1991. "Random Thoughts on the Debt." In Debt and the Twin

Deficits Debate, edited by J.R. Rock, 189-205. Mountain View, Calif.:

Bristlecone Books.